Chapter 18 - Equity Valuation Models

CHAPTER18:EQUITYVALUATIONMODELS
PROBLEMSETS
1.

Theoretically,dividenddiscountmodelscanbeusedtovaluethestockofrapidly
growingcompaniesthatdonotcurrentlypaydividends;inthisscenario,wewouldbe
valuingexpecteddividendsintherelativelymoredistantfuture.However,asapractical
matter,suchestimatesofpaymentstobemadeinthemoredistantfuturearenotoriously
inaccurate,renderingdividenddiscountmodelsproblematicforvaluationofsuch
companies;freecashflowmodelsaremorelikelytobeappropriate.Attheother
extreme,onewouldbemorelikelytochooseadividenddiscountmodeltovaluea
maturefirmpayingarelativelystabledividend.

2.

Itismostimportanttousemultistagedividenddiscountmodelswhenvaluing
companieswithtemporarilyhighgrowthrates.Thesecompaniestendtobecompanies
intheearlyphasesoftheirlifecycles,whentheyhavenumerousopportunitiesfor
reinvestment,resultinginrelativelyrapidgrowthandrelativelylowdividends(or,in
manycases,nodividendsatall).Asthesefirmsmature,attractiveinvestment
opportunitiesarelessnumeroussothatgrowthratesslow.

3.

Theintrinsicvalueofashareofstockistheindividualinvestorsassessmentofthetrue
worthofthestock.Themarketcapitalizationrateisthemarketconsensusforthe
requiredrateofreturnforthestock.Iftheintrinsicvalueofthestockisequaltoits
price,thenthemarketcapitalizationrateisequaltotheexpectedrateofreturn.Onthe
otherhand,iftheindividualinvestorbelievesthestockisunderpriced(i.e.,intrinsic
value<price),thenthatinvestorsexpectedrateofreturnisgreaterthanthemarket
capitalizationrate.

4.

a.

k=D1/P0+g
0.16=$2/$50+gg=0.12=12%

b.

P0=D1/(kg)=$2/(0.160.05)=$18.18
Thepricefallsinresponsetothemorepessimisticdividendforecast.The
forecastforcurrentyearearnings,however,isunchanged.Therefore,theP/E
ratiofalls.ThelowerP/Eratioisevidenceofthediminishedoptimism
concerningthefirm'sgrowthprospects.

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Chapter 18 - Equity Valuation Models

5.

a.

g=ROEb=16%0.5=8%
D1=$2(1b)=$2(10.5)=$1
P0=D1/(kg)=$1/(0.120.08)=$25

6.

b.

P3=P0(1+g)3=$25(1.08)3=$31.49

a.

k=rf+(rM)rf]=6%+1.25(14%6%)=16%
g=2/39%=6%
D1=E0(1+g)(1b)=$3(1.06)(1/3)=$1.06
D1
$1.06

$10.60
k g 0.16 0.06

P0

b.

LeadingP0/E1=$10.60/$3.18=3.33
TrailingP0/E0=$10.60/$3.00=3.53

c.

PVGO P0

E1
$3.18
$10.60
$9.275
k
0.16

ThelowP/EratiosandnegativePVGOareduetoapoorROE(9%)thatisless
thanthemarketcapitalizationrate(16%).
d. Now,yourevisebto1/3,gto1/39%=3%,andD1to:
E01.03(2/3)=$2.06
Thus:
V0=$2.06/(0.160.03)=$15.85
V0increasesbecausethefirmpaysoutmoreearningsinsteadofreinvestingapoor
ROE.Thisinformationisnotyetknowntotherestofthemarket.
7.

Sincebeta=1.0,thenk=marketreturn=15%
Therefore:
15%=D1/P0+g=4%+gg=11%

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Chapter 18 - Equity Valuation Models

8.

D1
$8

$160
k g 0.10 0.05

a.

P0

b.

Thedividendpayoutratiois8/12=2/3,sotheplowbackratioisb=1/3.The
impliedvalueofROEonfutureinvestmentsisfoundbysolving:
g=bROEwithg=5%andb=1/3ROE=15%

c.AssumingROE=k,priceisequalto:
P0

E1
$12

$120
k
0.10

Therefore,themarketispaying$40pershare($160$120)forgrowth
opportunities.
9.

a.

k=D1/P0+g
D1=0.5$2=$1
g=bROE=0.50.20=0.10
Therefore:k=($1/$10)+0.10=0.20=20%

b.

Sincek=ROE,theNPVoffutureinvestmentopportunitiesiszero:
PVGO P0

10.

E1
$10 $10 0
k

c.

Sincek=ROE,thestockpricewouldbeunaffectedbycuttingthedividendand
investingtheadditionalearnings.

a.

k=rf+[E(rM)rf]=8%+1.2(15%8%)=16.4%
g=bROE=0.620%=12%
V0

b.

D 0 (1 g )
$4 1.12

$101.82
k g
0.164 0.12

P1=V1=V0(1+g)=$101.821.12=$114.04

E(r )

D1 P1 P0 $4.48 $114.04 $100

0.1852 18.52%
P0
$100

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Chapter 18 - Equity Valuation Models

11.

Time:
Et
Dt
b
g
a.

0
$10.000
$0.000
1.00
20.0%

1
$12.000
$0.000
1.00
20.0%

5
$24.883
$0.000
1.00
20.0%

V5

D6
$11.944

$199.07
k g 0.15 0.09

V0

V5
$199.07

$98.97
5
(1 k )
1.15 5

6
$29.860
$11.944
0.60
9.0%

b. Thepriceshouldriseby15%peryearuntilyear6:becausethereisnodividend,the
entirereturnmustbeincapitalgains.
c.

ThepayoutratiowouldhavenoeffectonintrinsicvaluebecauseROE=k.

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Chapter 18 - Equity Valuation Models

13.

14.

ThesolutionsderivedfromSpreadsheet18.2areasfollows:
Intrinsicvalue:
Intrinsicvalue:
Intrinsicvalue
FCFF
FCFE
pershare:FCFF
a.
81,171
68,470
36.01

Intrinsicvalue
pershare:FCFE
37.83

b.

59,961

49,185

24.29

27.17

c.

69,813

57,913

29.73

32.00

Time:
Dt
g

0
$1.0000
25.0%

a.

1
$1.2500
25.0%

2
$1.5625
25.0%

3
$1.953125
5.0%

Thedividendtobepaidattheendofyear3isthefirstinstallmentofadividend
streamthatwillincreaseindefinitelyattheconstantgrowthrateof5%.Therefore,we
canusetheconstantgrowthmodelasoftheendofyear2inordertocalculate
intrinsicvaluebyaddingthepresentvalueofthefirsttwodividendsplusthepresent
valueofthepriceofthestockattheendofyear2.
Theexpectedprice2yearsfromnowis:
P2=D3/(kg)=$1.953125/(0.200.05)=$13.02
ThePVofthisexpectedpriceis:$13.02/1.202=$9.04
ThePVofexpecteddividendsinyears1and2is:
$1.25 $1.5625

$2.13
1.20
1.20 2

Thusthecurrentpriceshouldbe:$9.04+$2.13=$11.17
b. Expecteddividendyield=D1/P0=$1.25/$11.17=0.112=11.2%
c.

TheexpectedpriceoneyearfromnowisthePVatthattimeofP2andD2:
P1=(D2+P2)/1.20=($1.5625+$13.02)/1.20=$12.15
Theimpliedcapitalgainis:
(P1P0)/P0=($12.15$11.17)/$11.17=0.088=8.8%
Thesumoftheimpliedcapitalgainsyieldandtheexpecteddividendyieldisequal
tothemarketcapitalizationrate.ThisisconsistentwiththeDDM.

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Chapter 18 - Equity Valuation Models

15.

Time:
Et
Dt

0
$5.000
$0.000

1
$6.000
$0.000

4
$10.368
$0.000

5
$12.4416
$12.4416

Dividends=0forthenextfouryears,sob=1.0(100%plowbackratio).
a.

b.

16.

P4

D 5 $12.4416

$82.944
k
0.15

V0

P4
$82.944

$47.42
4
(1 k )
1.15 4

Priceshouldincreaseatarateof15%overthenextyear,sothattheHPRwill
equalk.

Beforetaxcashflowfromoperations
$2,100,000
Depreciation
210,000
TaxableIncome
1,890,000
Taxes(@35%)
661,500
Aftertaxunleveragedincome
1,228,500
Aftertaxcashflowfromoperations
(Aftertaxunleveragedincome+depreciation)
1,438,500
Newinvestment(20%ofcashflowfromoperations)
420,000
Freecashflow
(Aftertaxcashflowfromoperationsnewinvestment) $1,018,500
Thevalueofthefirm(i.e.,debtplusequity)is:
V0

C1
$1,018,500

$14,550,000
kg
0.12 0.05

Sincethevalueofthedebtis$4million,thevalueoftheequityis$10,550,000.
17.

a.

g=ROEb=20%0.5=10%
P0

D (1 g ) $0.50 1.10
D1
0

$11
k g
kg
0.15 0.10

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Chapter 18 - Equity Valuation Models

b.

c.

Time
0
1
2

EPS
$1.0000
$1.1000
$1.2100

$1.2826

Dividend Comment
$0.5000
$0.5500 g=10%,plowback=0.50
$0.7260 EPShasgrownby10%basedonlast
yearsearningsplowbackandROE;this
yearsearningsplowbackrationowfalls
to0.40andpayoutratio=0.60
$0.7696 EPSgrowsby(0.4)(15%)=6%and
payoutratio=0.60

Attime2: P2

D3
$0.7696

$8.551
k g 0.15 0.06

Attime0: V0

$0.55 $0.726 $8.551

$7.493
1.15
(1.15) 2

P0=$11andP1=P0(1+g)=$12.10
(Becausethemarketisunawareofthechangedcompetitivesituation,itbelievesthe
stockpriceshouldgrowat10%peryear.)
P2=$8.551afterthemarketbecomesawareofthechangedcompetitivesituation.
P3=$8.5511.06=$9.064(Thenewgrowthrateis6%.)
Year
1
2
3

Return

($12.10 $11) $0.55

0.150 15.0%
$11
($8.551 $12.10) $0.726
0.233 23.3%
$12.10
($9.064 $8.551) $0.7696
0.150 15.0%
$8.551

Moral:In"normalperiods"whenthereisnospecialinformation,
thestockreturn=k=15%.Whenspecialinformationarrives,alltheabnormal
returnaccruesinthatperiod,asonewouldexpectinanefficientmarket.
CFAPROBLEMS
1.

P0=D1/(kg)=$2.10/(0.110)=$19.09

2.

IandII

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Chapter 18 - Equity Valuation Models

3.

a.

Thisdirectorisconfused.Inthecontextoftheconstantgrowthmodel
[i.e.,P0=D1/(kg)],itistruethatpriceishigherwhendividendsarehigher
holdingeverythingelseincludingdividendgrowthconstant.Buteverythingelsewill
notbeconstant.Ifthefirmincreasesthedividendpayoutrate,thegrowthrategwill
fall,andstockpricewillnotnecessarilyrise.Infact,ifROE>k,pricewillfall.

b.

(i)Anincreaseindividendpayoutwillreducethesustainablegrowthrateasless
fundsarereinvestedinthefirm.Thesustainablegrowthrate
(i.e.,ROEplowback)willfallasplowbackratiofalls.
(ii)Theincreaseddividendpayoutratewillreducethegrowthrateofbookvalue
forthesamereasonlessfundsarereinvestedinthefirm.

4.

Usingatwostagedividenddiscountmodel,thecurrentvalueofashareofSundanciis
calculatedasfollows.
D3
D1
D2
(k g)
V0

1
2
(1 k ) (1 k )
(1 k ) 2

$0.5623
$0.3770 $0.4976 (0.14 0.13)

$43.98
1.141
1.14 2
1.14 2

where:
E0=$0.952
D0=$0.286
E1=E0(1.32)1=$0.9521.32=$1.2566
D1=E10.30=$1.25660.30=$0.3770
E2=E0(1.32)2=$0.952(1.32)2=$1.6588
D2=E20.30=$1.65880.30=$0.4976
E3=E0(1.32)21.13=$0.952(1.32)31.13=$1.8744
D3=E30.30=$1.87430.30=$0.5623

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Chapter 18 - Equity Valuation Models

5.

a.

Freecashflowtoequity(FCFE)isdefinedasthecashflowremainingafter
meetingallfinancialobligations(includingdebtpayment)andaftercovering
capitalexpenditureandworkingcapitalneeds.TheFCFEisameasureofhow
muchthefirmcanaffordtopayoutasdividends,butinagivenyearmaybemore
orlessthantheamountactuallypaidout.
Sundanci'sFCFEfortheyear2008iscomputedasfollows:

FCFE =
Earnings after tax + Depreciation expense Capital expenditures Increase in NWC
=$80million+$23million$38million$41million=$24million
FCFEpershare=FCFE/numberofsharesoutstanding
=$24million/84millionshares=$0.286
Atthegivendividendpayoutratio,Sundanci'sFCFEpershareequalsdividends
pershare.
b.

TheFCFEmodelrequiresforecastsofFCFEforthehighgrowthyears(2009and
2010)plusaforecastforthefirstyearofstablegrowth(2011)inordertotoallow
foranestimateoftheterminalvaluein2010basedonperpetualgrowth.Because
allofthecomponentsofFCFEareexpectedtogrowatthesamerate,thevalues
canbeobtainedbyprojectingtheFCFEatthecommonrate.(Alternatively,the
componentsofFCFEcanbeprojectedandaggregatedforeachyear.)
ThefollowingtableshowstheprocessforestimatingSundanci'scurrentvalueona
persharebasis.

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Chapter 18 - Equity Valuation Models

FreeCashFlowtoEquity
BaseAssumptions
Sharesoutstanding:84million
Requiredreturnonequity(r):14%
Actual
2008
Growthrate(g)
Earningsaftertax
Plus:Depreciationexpense
Less:Capitalexpenditures
Less:Increaseinnetworkingcapital
Equals:FCFE
Terminalvalue
Totalcashflowstoequity
Discountedvalue
Currentvaluepershare

Total
$80
$23
$38
$41
$24

Pershare
$0.952
$0.274
$0.452
$0.488
$0.286

Projected
2009
27%

Projected
2010
27%

Projected
2011
13%

$1.2090
$0.3480
$0.5740
$0.6198
$0.3632

$1.5355
$1.7351
$0.4419
$0.4994
$0.7290
$0.8238
$0.7871
$0.8894
$0.4613
$0.5213
$52.1300*
$0.3632
$52.5913**
$0.3186*** $40.4673***
$40.7859****

*Projected2010Terminalvalue=(Projected2011FCFE)/(rg)
**Projected2010Totalcashflowstoequity=
Projected2010FCFE+Projected2010Terminalvalue
***Discountedvaluesobtainedusingr=14%
****Currentvaluepershare=
SumofDiscountedProjected2009and2010Totalcashflowstoequity
c.

i.TheDDMusesastrictdefinitionofcashflowstoequity,i.e.theexpecteddividends
onthecommonstock.Infact,takentoitsextreme,theDDMcannotbeusedtoestimate
thevalueofastockthatpaysnodividends.TheFCFEmodelexpandsthedefinitionof
cashflowstoincludethebalanceofresidualcashflowsafterallfinancialobligations
andinvestmentneedshavebeenmet.ThustheFCFEmodelexplicitlyrecognizesthe
firmsinvestmentandfinancingpoliciesaswellasitsdividendpolicy.Ininstancesofa
changeofcorporatecontrol,andthereforethepossibilityofchangingdividendpolicy,
theFCFEmodelprovidesabetterestimateofvalue.TheDDMisbiasedtowardfinding
lowP/Eratiostockswithhighdividendyieldstobeundervaluedandconversely,high
P/Eratiostockswithlowdividendyieldstobeovervalued.Itisconsidereda
conservativemodelinthatittendstoidentifyfewerundervaluedfirmsasmarketprices
riserelativetofundamentals.TheDDMdoesnotallowforthepotentialtax
disadvantageofhighdividendsrelativetothecapitalgainsachievablefromretentionof
earnings.

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Chapter 18 - Equity Valuation Models

ii.Bothtwostagevaluationmodelsallowfortwodistinctphasesofgrowth,aninitial
finiteperiodwherethegrowthrateisabnormal,followedbyastablegrowthperiodthat
isexpectedtolastindefinitely.Thesetwostagemodelssharethesamelimitationswith
respecttothegrowthassumptions.First,thereisthedifficultyofdefiningtheduration
oftheextraordinarygrowthperiod.Forexample,alongerperiodofhighgrowthwill
leadtoahighervaluation,andthereisthetemptationtoassumeanunrealisticallylong
periodofextraordinarygrowth.Second,theassumptionofasuddenshiftfromhigh
growthtolower,stablegrowthisunrealistic.Thetransformationismorelikelytooccur
gradually,overaperiodoftime.Giventhattheassumedtotalhorizondoesnotshift
(i.e.,isinfinite),thetimingoftheshiftfromhightostablegrowthisacritical
determinantofthevaluationestimate.Third,becausethevalueisquitesensitivetothe
steadystategrowthassumption,overorunderestimatingthisratecanleadtolarge
errorsinvalue.Thetwomodelsshareotherlimitationsaswell,notablydifficultiesin
accuratelyforecastingrequiredratesofreturn,indealingwiththedistortionsthatresult
fromsubstantialand/orvolatiledebtratios,andinaccuratelyvaluingassetsthatdonot
generateanycashflows.
6.

a.

Theformulaforcalculatingapriceearningsratio(P/E)forastablegrowthfirmis
thedividendpayoutratiodividedbythedifferencebetweentherequiredrateof
returnandthegrowthrateofdividends.IftheP/Eiscalculatedbasedontrailing
earnings(year0),thepayoutratioisincreasedbythegrowthrate.IftheP/Eis
calculatedbasedonnextyearsearnings(year1),thenumeratoristhepayoutratio.
P/E on trailing earnings:
P/E = [payout ratio (1 + g)]/(r g) = [0.30 1.13]/(0.14 0.13) = 33.9
P/Eonnextyear'searnings:
P/E = payout ratio/(r g) = 0.30/(0.14 0.13) = 30.0

b.

TheP/Eratioisadecreasingfunctionofriskiness;asriskincreases,theP/Eratio
decreases.IncreasesintheriskinessofSundancistockwouldbeexpectedtolowerthe
P/Eratio.
TheP/Eratioisanincreasingfunctionofthegrowthrateofthefirm;thehigherthe
expectedgrowth,thehighertheP/Eratio.SundanciwouldcommandahigherP/Eif
analystsincreasetheexpectedgrowthrate.
TheP/Eratioisadecreasingfunctionofthemarketriskpremium.Anincreased
marketriskpremiumincreasestherequiredrateofreturn,loweringthepriceofa
stockrelativetoitsearnings.Ahighermarketriskpremiumwouldbeexpectedto
lowerSundanci'sP/Eratio.

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Chapter 18 - Equity Valuation Models

7.

a.

The sustainable growth rate is equal to:

plowback ratio return on equity = b ROE
where
b = [Net Income (Dividend per share shares outstanding)]/Net Income
ROE = Net Income/Beginning of year equity
In 2005:
b = [208 (0.80 100)]/208 = 0.6154
ROE = 208/1380 = 0.1507
Sustainable growth rate = 0.6154 0.1507 = 9.3%
In 2008:
b = [275 (0.80 100)]/275 = 0.7091
ROE = 275/1836 = 0.1498
Sustainable growth rate = 0.7091 0.1498 = 10.6%

b.
i. The increased retention ratio increased the sustainable growth rate.
Retention ratio = [Net Income (Dividend per share shares outstanding)]/Net Income
Retention ratio increased from 0.6154 in 2005 to 0.7091 in 2008.
This increase in the retention ratio directly increased the sustainable growth rate
because the retention ratio is one of the two factors determining the sustainable
growth rate.
ii. The decrease in leverage reduced the sustainable growth rate.
Financial leverage = (Total Assets/Beginning of year equity)
Financial leverage decreased from 2.34 (= 3230/1380) at the beginning of 2005 to 2.10
at the beginning of 2008 (= 3856/1836)
This decrease in leverage directly decreased ROE (and thus the sustainable growth rate)
because financial leverage is one of the factors determining ROE (and ROE is one of the
two factors determining the sustainable growth rate).
8.

a.

The formula for the Gordon model is:

V0 = [D0 (1 + g)]/(r g)
where:
D0 = dividend paid at time of valuation
g = annual growth rate of dividends
r = required rate of return for equity
In the above formula, P0, the market price of the common stock, substitutes for V0
and g becomes the dividend growth rate implied by the market:
P0 = [D0 (1 + g)]/(r g)
Substituting, we have:
58.49 = [0.80 (1 + g)]/(0.08 g) g = 6.54%

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Chapter 18 - Equity Valuation Models

9.

b.

Use of the Gordon growth model would be inappropriate to value Dynamics

common stock, for the following reasons:
i. The Gordon growth model assumes a set of relationships about the growth rate for
dividends, earnings, and stock values. Specifically, the model assumes that dividends,
earnings, and stock values will grow at the same constant rate. In valuing Dynamics
common stock, the Gordon growth model is inappropriate because managements
dividend policy has held dividends constant in dollar amount although earnings have
grown, thus reducing the payout ratio. This policy is inconsistent with the Gordon
model assumption that the payout ratio is constant.
ii. It could also be argued that use of the Gordon model, given Dynamics current
dividend policy, violates one of the general conditions for suitability of the model,
namely that the companys dividend policy bears an understandable and consistent
relationship with the companys profitability.

a.

TheindustrysestimatedP/Ecanbecomputedusingthefollowingmodel:
P0/E1=payoutratio/(rg)
However,sincerandgarenotexplicitlygiven,theymustbecomputedusingthe
followingformulas:
gind=ROEretentionrate=0.250.40=0.10
rind=governmentbondyield+(industrybetaequityriskpremium)
=0.06 + (1.2 0.05) = 0.12
Therefore:
P0/E1=0.60/(0.120.10)=30.0

b.

i.ForecastgrowthinrealGDPwouldcauseP/Eratiostobegenerallyhigherfor
CountryA.HigherexpectedgrowthinGDPimplieshigherearningsgrowthanda
higherP/E.
ii.GovernmentbondyieldwouldcauseP/Eratiostobegenerallyhigherfor
CountryB.Alowergovernmentbondyieldimpliesalowerriskfreerateand
thereforeahigherP/E.
iii.EquityriskpremiumwouldcauseP/EratiostobegenerallyhigherforCountry
B.AlowerequityriskpremiumimpliesalowerrequiredreturnandahigherP/E.

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Chapter 18 - Equity Valuation Models

10.

a.
b.

k=rf+(rM)rf]=4.5%+1.15(14.5%4.5%)=16%
Year
2009

Dividend
$1.72

2010

$1.721.12=

$1.93

2011

$1.721.122=

$2.16

2012

$1.721.123=

$2.42

2013

$1.721.1231.09=

$2.63

Presentvalueofdividendspaidin20102012:
Year
2010
2011
2012

PVofDividend
$1.93/1.161=
$2.16/1.162=
$2.42/1.163=
Total=

Priceatyearend2012

$1.66
$1.61
$1.55
$4.82
D 2013
$2.63

$37.57
kg
0.16 0.09

PVin2009ofthisstockprice

$37.57
$24.07
1.16 3

Intrinsicvalueofstock=$4.82+$24.07=$28.89
c.

ThedataintheproblemindicatethatQuickBrushissellingatapricesubstantially
belowitsintrinsicvalue,whilethecalculationsabovedemonstratethat
SmileWhiteissellingatapricesomewhatabovetheestimateofitsintrinsicvalue.
Basedonthisanalysis,QuickBrushoffersthepotentialforconsiderableabnormal
returns,whileSmileWhiteoffersslightlybelowmarketriskadjustedreturns.

d.

StrengthsoftwostageversusconstantgrowthDDM:
Twostagemodelallowsforseparatevaluationoftwodistinctperiodsina
companysfuture.Thiscanaccommodatelifecycleeffects.Italsocanavoidthe
difficultiesposedbyinitialgrowththatishigherthanthediscountrate.
Twostagemodelallowsforinitialperiodofabovesustainablegrowth.Itallows
theanalysttomakeuseofherexpectationsregardingwhengrowthmightshift
fromofftrendtoamoresustainablelevel.
AweaknessofallDDMsisthattheyareverysensitivetoinputvalues.Small
changesinkorgcanimplylargechangesinestimatedintrinsicvalue.These
inputsaredifficulttomeasure.

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Chapter 18 - Equity Valuation Models

11.

a.

ThevalueofashareofRioNationalequityusingtheGordongrowthmodeland
thecapitalassetpricingmodelis$22.40,asshownbelow.
Calculatetherequiredrateofreturnusingthecapitalassetpricingmodel:
k=rf+(kMrf)=4%+1.8(9%4%)=13%
CalculatethesharevalueusingtheGordongrowthmodel:
P0

b.

D o (1 g) $0.20 (1 0.12)

$22.40
kg
0.13 0.12

ThesustainablegrowthrateofRioNationalis9.97%,calculatedasfollows:

g=bROE=EarningsRetentionRateROE=(1PayoutRatio)ROE=

12.

a.

Dividends
Net Income
$3.20
$30.16

1
0.0997 9.97%


Net Income Beginning Equity
$30.16 $270.35

Toobtainfreecashflowtoequity(FCFE),thetwoadjustmentsthatShaarshould
maketocashflowfromoperations(CFO)are:
1. Subtractinvestmentinfixedcapital:CFOdoesnottakeintoaccountthe
investingactivitiesinlongtermassets,particularlyplantandequipment.The
cashflowscorrespondingtothosenecessaryexpendituresarenotavailableto
equityholdersandthereforeshouldbesubtractedfromCFOtoobtainFCFE.
2. Addnetborrowing:CFOdoesnottakeintoaccounttheamountofcapital
suppliedtothefirmbylenders(e.g.,bondholders).Thenewborrowings,netof
debtrepayment,arecashflowsavailabletoequityholdersandshouldbeadded
toCFOtoobtainFCFE.

b.

Note1:RioNationalhad$75millionincapitalexpendituresduringtheyear.
Adjustment:negative$75million
Thecashflowsrequiredforthosecapitalexpenditures($75million)arenolonger
availabletotheequityholdersandshouldbesubtractedfromnetincometoobtain
FCFE.

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Chapter 18 - Equity Valuation Models

Note2:Apieceofequipmentthatwasoriginallypurchasedfor$10millionwassold
for$7millionatyearend,whenithadanetbookvalueof$3million.Equipment
salesareunusualforRioNational.
Adjustment:positive$3million
IncalculatingFCFE,onlycashflowinvestmentsinfixedcapitalshouldbe
considered.The$7millionsalepriceofequipmentisacashinflownowavailableto
equityholdersandshouldbeaddedtonetincome.However,thegainoverbook
valuethatwasrealizedwhensellingtheequipment($4million)isalreadyincluded
innetincome.Becausethetotalsaleiscash,notjustthegain,the$3millionnet
bookvaluemustbeaddedtonetincome.Therefore,theadjustmentcalculationis:
$7millionincashreceived$4millionofgainrecordedinnetincome=
$3millionadditionalcashreceivedaddedtonetincometoobtainFCFE.
Note3:Thedecreaseinlongtermdebtrepresentsanunscheduledprincipal
repayment;therewasnonewborrowingduringtheyear.
Adjustment:negative$5million
Theunscheduleddebtrepaymentcashflow($5million)isanamountnolonger
availabletoequityholdersandshouldbesubtractedfromnetincometodetermine
FCFE.
Note4:OnJanuary1,2008,thecompanyreceivedcashfromissuing400,000
sharesofcommonequityatapriceof$25.00pershare.
Noadjustment
TransactionsbetweenthefirmanditsshareholdersdonotaffectFCFE.To
calculateFCFE,therefore,noadjustmenttonetincomeisrequiredwithrespect
totheissuanceofnewshares.
Note5:Anewappraisalduringtheyearincreasedtheestimatedmarketvalueof
landheldforinvestmentby$2million,whichwasnotrecognizedin2008income.
Noadjustment
Theincreasedmarketvalueofthelanddidnotgenerateanycashflowandwasnot
reflectedinnetincome.TocalculateFCFE,therefore,noadjustmenttonetincome
isrequired.

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Chapter 18 - Equity Valuation Models

c.

Freecashflowtoequity(FCFE)iscalculatedasfollows:
FCFE=NI+NCCFCINVWCINV+NetBorrowing
where NCC=noncashcharges
FCINV=investmentinfixedcapital
WCINV=investmentinworkingcapital
Million$
$30.16
+$67.17

NI=
NCC=
FCINV=

$68.00

WCINV=

$24.00

NetBorrowing=
FCFE=

+($5.00)
$0.33

Explanation
FromTable18G
$71.17(depreciationandamortizationfromTable18G)
$4.00*(gainonsalefromNote2)
$75.00(capitalexpendituresfromNote1)
$7.00*(cashonsalefromNote2)
$3.00(increaseinaccountsreceivablefromTable18F)+
$20.00(increaseininventoryfromTable18F)+
$1.00(decreaseinaccountspayablefromTable18F)
$5.00(decreaseinlongtermdebtfromTable18F)

*SupplementalNote2inTable18HaffectsbothNCCandFCINV.
13.

RioNationalsequityisrelativelyundervaluedcomparedtotheindustryonaP/Etogrowth
(PEG)basis.RioNationalsPEGratioof1.33isbelowtheindustryPEGratioof1.66.The
lowerPEGratioisattractivebecauseitimpliesthatthegrowthrateatRioNationalis
availableatarelativelylowerpricethanisthecasefortheindustry.ThePEGratiosforRio
Nationalandtheindustryarecalculatedbelow:
RioNational
CurrentPrice=$25.00
NormalizedEarningsperShare=$1.71
PricetoEarningsRatio=$25/$1.71=14.62
GrowthRate(asapercentage)=11
PEGRatio=14.62/11=1.33
Industry
PricetoEarningsRatio=19.90
GrowthRate(asapercentage)=12
PEGRatio=19.90/12=1.66

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